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Financial Reform Is a Joke

Congress has completely missed its opportunity to make the financial system safer.

I don't normally keep a close eye on what's going on in Washington -- and now I remember why. Following the so-called progress that Congress has made in putting together a financial reform bill has been downright depressing. As we lurch ever closer to a bill that lawmakers will call "reform," I find myself with little hair left to yank out in frustration.

A very vegetarian billBack in April, I laid out the primary pain points that Congress should be addressing. In fairness, some of those issues will likely be addressed. Much to the chagrin of Moody's(NYSE: MCO) and Standard & Poor's, it does look like the rules of the ratings game will change. And (cross your fingers), the tough derivatives changes could make it through the lobbyist gauntlet and end up as law.

However, in my laundry list back in April, the top two issues that I highlighted were regulating the shadow banking industry and ending too big to fail. The proposed legislation does little (if anything) to address either area.

Basically, it's as if Congress has laid out a sesame seed bun, lettuce, tomatoes, onions, pickles, and heck, maybe even some delicious special sauce. But it's completely forgotten the meat.

Unfortunately, supposed expert insiders aren't helping the situation here, either. Earlier this month, Bloomberg quoted former Fed Chairman Paul Volcker saying that the reform bill gets the "basic points pretty much right." In the same article, Volcker pointed out that the shadow banking system will still need to be addressed in the future. And in a more recent appearance on CNBC, Volcker added that the bill's resolution authority would probably not be workable for the megabanks like Bank of America(NYSE: BAC) and Citigroup(NYSE: C).

As much respect as I have for Volcker, I can't help but wonder: What "basic points" does this legislation get right?

Crisis ahead!Congress seems to have the insane belief that we can prevent financial crises and individual bank failures. The provisions that appear ready to be put in place are primarily focused on identifying problems and correcting them before they lead to failure.

That sort of prevention just ain't gonna happen.

Cycles will happen, mistakes will be made again, and regulators will (again!) fail to head off calamity. And while I don't think it's a bad idea to attempt prevention, its importance pales in comparison to making sure banks are small enough and contained enough to fail without shaking the foundation of our entire financial system.

What do we have instead? As I pointed out in a previous article, we have silly statements that say, "We will not bail you out," yet effect no meaningful changes in the system to reduce the need for bailouts. The inevitable result? Banks will go wild all over again, leaving the the American public once more forced to choose between bailouts and systemic cataclysm.

I certainly don't think it would prevent the turmoil coming up, and I doubt very much it would have had much impact on the turmoil we have just experienced ... You might surmise from that that I'm not a fan.

Federal Reserve Bank of Philadelphia President Charles Plosser recently argued that "too big to fail" should be the cornerstone of reform:

In my view, the most important element in fixing our financial system is that we must end the notion that some financial firms are too big or too interconnected to fail.

But according to Plosser, the legislation looks like it will fall short. "I don't think we've got the Too-Big-To-Fail problem solved in this legislation," he said.

Their stupidity = your gain?While the toothlessness of the financial reform bill makes me fret over our economic and financial health, it also suggests that opportunity may be knocking.

The cloud of uncertainty hanging over the biggest banks -- that's JPMorgan Chase(NYSE: JPM) and Wells Fargo(NYSE: WFC), in addition to B of A and Citi -- may owe to assumptions of a more draconian reform outcome. That sentiment could be doubly true for quasi-banks Morgan Stanley(NYSE: MS) and Goldman Sachs(NYSE: GS).

The new legislation will almost certainly hurt profitability at these institutions, but the impact will be far more modest than it could (should!) have been. This group is already beginning to rake in serious profits again, and I suspect that in the coming years, we'll only see that accelerate.

Of course, given the precarious state in which Congress will leave the financial system, I would not recommend letting these financial folks mingle with more stable long-term investments. While this group could offer short term gains, unless we get some piggybacking legislation, we'll eventually see these big banks back on the ropes again.